Risk and Return in the 20th and 21st Centuries
Posted: 5 Mar 2001
The single most important contemporary issue in finance is the equity risk premium. This drives future equity returns, and is the key determinant of the cost of capital. The risk premium, the expected reward for bearing the risk of investing in equities, rather than in low-risk investments such as bills or bonds, is usually estimated from historical data. This article starts by summarising new evidence on historical returns in twelve major world markets from the authors' recent book, 'The Millennium Book: A Century of Investment Returns'. The authors show that the historical equity risk premium has been lower than previously believed, and argue that the future risk premium is likely to be lower still. They discuss what this implies for the cost of capital, stock market values, and companies' target rates of return. They suggest that many companies are seeking too high a rate of return and thus run the risk of under-investing.
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